Regulation Fever and the Banking Sector

It appears as if we are on the other side of the tidal wave of financial disruption that we have been facing over the past eight or nine months. Some rather charge-offs are still being reported, and earnings are not going to recover for a while, but, these are now taking place in an orderly fashion. The hope is that banks and other financial institutions have gotten their arms around their problems and are working things out day-by-day.

This is the way things usually work out during these periods of financial upheaval. There is the shock of realization that things are not as they are thought to be, and then there is the sell-off, followed by the intervention of the central bank, and finally, people begin working out things in as orderly fashion as possible. Time is what is needed, and the actions of the central bank are aimed at buying time so that the institutions involved will have the time needed to clean up their balance sheets.

Having both a liquidity crisis and a solvency crisis is a scary. There is so much uncertainty because when these events begin there is so little information available. We don’t know what is happening. We don't know what or how severe the problem is.

Markets hate uncertainty!

However, things are being worked out. Institutions seem to be getting their balance sheets under control and are re-constructing themselves for the future. We can only hope that we are not going to be surprised again. We can only hope that all the banks and other financial firms that were impacted have the time they need to regain their strength. The economy is still not ‘out-of-the-woods’ and this, too, will take time. People are aware and are responding to the recession-like environment, but the next year or two will not be an easy time.

What is interesting to me is that there are people that are already wringing their hands over the missed opportunity to massively re-regulate the financial system. In an article that appeared in the May 5, 2008 edition of the New York Times, Paul Krugman wrote:

The bad news is that as markets stabilize, chances for fundamental financial reform may be slipping away. As a result the next crisis will probably be worse than this one.

I don’t want to concentrate on the ‘fear’ connected with the next crisis. That is just Dramatics 101. Let’s look at the other side of this introducing of ‘fundamental financial reform.’ First of all, when was this reform going to be instituted? Trying to legislate reforms of the financial system at the peak of the liquidity crisis is NOT the time to change the regulations and the regulatory structure! One really doesn’t know what the problems are at that time and the responses to the situation usually are about ‘outcomes’ because outcomes are what catch the attention of the press and the public. People want to legislate ‘results.’ Instituting good changes require an understanding of the problem and a focus on ‘processes,’ on how organizations do business. This understanding only comes with time and study.

Also, is it wise to implement all new sorts of rules and regulations at a time when the banks and other financial institutions are going through their ‘working out’ efforts? These organizations need to focus on the ‘business at hand’ and not on commenting on, fighting for, or implementing any new legislation with regards to the way they do business. If you want to cause further trouble, get these institutions to focus on things that are not the immediate problem! No, they need to keep their attention on working their way out of the mess and this cannot be done immediately.

Now, let’s look at the next issue Krugman brings up:

After the financial crisis that ushered in the Great Depression, New Deal reformers regulated the banking system with the goal of protecting the economy from future crises. The new system worked well for half a century.

I can’t believe that Krugman feels that for 50 years the ‘new’ system worked and then, all-of-a-sudden, banks and other financial institutions began to innovate and create all of these new financial instruments that resulted in the situation we are now facing. That would mean that we made it into the 1980s before all of this innovation began to take place.

If one looks back to the 1960s one can see the beginnings of the financial innovation. The 1940s saw the world at war and the 1950s was a relatively tranquil period that brought back some ‘normalcy’ to life (whatever ‘normalcy means). In the 1960s we saw some financial innovation or innovative use of financial instruments that had not existed before. These were given names like Federal Funds, negotiable CDs, and Eurodollars. These innovations allowed commercial banks to readily obtain funds from sources that were not limited to the bank’s ‘local’ area, whether a state or a more limited area in ‘unit’ banking states.

My experience in the Federal Reserve System going into the 1970s was that the banking system was about 6-9 months ahead of the regulators with respect to some of these instruments. That is, the banks would do something to get around regulations and it would take the regulators from 6 to 9 months to find out what the banks were trying to do and then close the ‘loophole.’ Then, the whole process would begin again.

This was just a start. With the new electronic technology, banks could cross regulatory lines and break down the barriers to state banking restrictions. When I was teaching at the Wharton School I wrote articles about the fact that commercial banks were already regional or national in scope because the new information technology allowed them to draw from out of their areas to conduct banking business and the regulators could do little or nothing to stop the ‘innovation.’

Innovation is going to take place! Regulation is always going to be behind the curve! Legislators and regulators are always going to be playing ‘catch up’! That is the way the world works!

What do I suggest? There is not much space to go into this too deeply in this post, but I would like to make one suggestion. I firmly believe in openness and transparency. I believe that trying to open up reporting requirements would help the situation immensely. Several areas immediately come to mind that would help, but let me present three:

The first has to do with the market value of assets. I can understand why some institutions do not want to regularly adjust balance sheets for the market value of their assets - both securities and loans - but at a minimum, these values, even if estimated, should be noted in their required releases. My belief is that if the people within these organizations know that these data are going to have to be released it will give them greater incentive to act on their problems earlier rather than later.

My experience in turning around banks underscores the behavior of organizations that get into trouble. They keep postponing taking any action, and keep thinking that the markets will ‘turnaround.’ However, in most cases, they don’t!

Second, I believe that assets should not be allowed to exist ‘off’ balance sheet. All assets need to be reported and need to have sufficient capital supporting them. Putting something ‘off’ balance sheet does not eliminate the need to support them, and the investment community needs to know of their existence. The more ‘daylight’ that exists, the better these assets will be managed.

Third, transactions need to be reported. Long Term Capital Management made the point repeatedly that the spreads they worked on were so narrow that they couldn’t release the information on them because others could then duplicate their deals. If the spreads are so narrow that the ‘deals’ require massive amounts of leverage to make them work, and if the spreads are so narrow that information on the deals cannot be released, I say, let the information be released! Let the spreads go away!